Index funds again

I’m feeling lazy today, so here’s a cut and paste response that I posted to a question in LYN:

Can someone recommend some unit trust fund managers for KLCI INDEX fund? Is the OSK KLCI Tracker the only KLCI index fund around? I cannot believe this. Why other fund managers don’t setup an index fund? Why let OSK monopoly? I can’t even find two to compare and see which is cheaper.

Late reply, but this is something that I’ve wondered about in the past on this very forum as well. If you read a lot of general investment advice that comes out of experience in the US markets, the general consensus you should get is that most ordinary people should just buy index funds and forget about everything else. The rationale is that research has definitively demonstrated that over the long run, index funds in the aggregate outperform actively managed funds once you account for the higher costs associated with the managed funds. While it is possible for managed funds to beat the index, research has shown that it is not generally possible to predict in advance which particular managed fund will beat its benchmark index in any particular year. Research has also shown that the simple strategy of choosing the best performer of last year to invest in every year is a losing one.

However, I’ve come to realize that for many different reasons many of these things don’t really apply to Malaysia. Some of these reasons include:

1) The U.S. is a mature and deep market with extremely high liquidity and lots of players. The Malaysian market is puny in comparison and dominated by some extremely big players, including the government. This means that unlike the mature U.S. market which lacks arbitrage opportunities because the market is deep enough that the prices should reflect all relevant information available to all market participants, it is still possible for investors in the Malaysia to identify and exploit arbitrage opportunities due to factors such as information disparity (some market participants know some things that others don’t) and the fact that in some cases government-linked companies and investors are “forced” to act in a certain way and everyone knows this.

2) U.S. index funds are really, really cheap, in some cases as cheap as 0.15% a year. No Malaysian index fund can match that. This makes Malaysian index funds a lot less worthwhile. As I’ve previously mentioned, if “alpha” comes so cheap, why not just buy it? This raises the question of why index funds are so expensive in Malaysia and why no new competitors have entered the field offering low costs? One part of the reason is obvious. An index fund, since it is not actively managed, should have relatively fixed costs and very, very low marginal costs. In other words, it takes a certain amount of money to establish and keep a fund running, but each new customer adds almost nothing in terms of extra costs. Because the U.S. market is so huge, this means that it is possible for the U.S. index funds to spread their costs around to a very large number of customers. The Malaysian index funds can’t do that, so their costs will always be higher.

3) Another reason I can think of is that the various investment funds in Malaysia are heavily reliant on a network of sales agents to sell and service them. On the other hand, if all you want is to invest in an index fund in the US, there’s no way the fund is going to send an agent to you and offer you a personalized, one-on-one service. Since agents are paid commissions that are ultimately paid from the fund’s management fees, obviously any fund that wants to make a serious dent in its fees must find a way to do without them. For various reasons, such as the lower level of financial education amongst Malaysians, this might not be feasible. Or else Malaysians might feel more of a psychological need to speak with a human sales agent to ask questions and solve problems for them.

4) Malaysians are not comfortable with the idea that matching a benchmark is good enough. They do not want average returns. They want exceptional returns, every year. Once again, this is a logical impossibility: it is not possible for everyone in the market to be doing above average at the same time. For every one that is, someone must be doing below average. However, it is possible that most Malaysians have not yet overcome the psychological hurdle that the returns on their personal investments are more likely than not going to be average over the long run and thus eschew index funds on principle because these funds by definition offer only average returns.

11 thoughts on “Index funds again”

  1. Hi, came to this post from your earlier post on the same subject where you had expressed frustration on the high costs imposed by the so-called index funds that are on sale here. All four reasons you’ve given are highly plausible (although I do wish I could buy and sell directly, instead of relying on an agent).

    Also, here in Malaysia, we don’t pay capital gains taxes; so as a result the alpha could really buy and sell without having to pay high short-term capital gains taxes, which is the case in the US. So, even funds with high turnover could aspire to, and do, give better returns, I think.

  2. Yeah, that last point is a good one. The lack of capital gains taxes is a good reason why true index funds aren’t worthwhile in Malaysia. I should have thought of that myself. Thanks for the input!

  3. So, you still don’t know if Malaysians can purchase overseas index funds? The whole agent system in Malaysia is bullcrap. The agent you are buying from probably knows less than you, such as in insurance (I was an insurance agent).

  4. There’s no reason why Malaysians can’t buy overseas index funds. It’s just a matter of actually going through the hassle of doing so. But in general this post is now somewhat out of date. Those interested in mutual funds should check out fundsupermart.com.my which is a portal for buying a variety of mutual funds run by various investment banks in Malaysia. It’s a way to get around the agent system by buying online resulting in significantly lower sales charges. Annual management fees are still the same though and there are still no really cheap index funds as far as know since all of them are still alpha-funds.

  5. Thanks for replying. Sigh, so that means Malaysians don’t get to to enjoy investing in index funds? What kind of hassle? If purchased through fundsupermart, do we really own the shares?

  6. I suppose the hassle of buying foreign-based index funds might include physically travelling the the country where it is sold. I have no idea if there are any reputable foreign fund managers who allow online sales. For example, I don’t think the US-based Vanguard allows foreigners to buy their funds online but I may be wrong.

    Funds purchased through fundsupermart is no different from buying it directly from the respective investment banks. In effect, the website is acting as the sales agent. So the safety depends on whether or not you trust those investment banks and Bank Negara’s rules regarding the regulation of unit trust investments in the first place.

  7. I see. What about the FBMKLCI-EA? Is it good? I read that ETFs lose to index funds when it comes to transaction costs? To breakeven you need to hold $13,000 for 10 years? I don’t really understand that part. I can’t share the link it seems, but google “ETF vs Index funds”, it’s an Investopedia article. So basically, the market in Malaysia is limited to mutual funds? Are there any alternative investments that are like indexes? Thanks again man. 

  8. As a Managing Wealth Consultant it pains me to agree with all the comments about the inexperience of the “agents” that sell financial products. 
    While agents are big culprits I would like to point out the bigger culprits are actually the banks’ personal financial consultants (PFC)
    Banks give these young inexperienced PFCs KPI to sell products. Usually these ZERO benefits to the customer ex. Call Warrants that expire in 6 months that are deep out of the money or massive premiums so that the bank NEVER loses.
    This is especially sad when these instruments are sold to the Grandpa’s and Pak Chiks who have no understanding and no need for such risk.
    Next let’s visit those fund houses that have so many types of funds for sale. It’s like they are trying to get their agents to up-sell other flavour-of-the-month themes. Invariably these themes by the time the fund houses decide to create funds to sell are at the tail end. Recall all those Dragon funds, Vietnam funds, Gold funds etc….
    Going back to the cost of investing in Unit Trusts. Yes it is high here in Malaysia, at an average of 5.5%
    If I may put a short plug here…
    If one is looking at investments as a long term process, 5.5% is not too much if you’re allowed to limitlessly switch between equity funds from different fund houses.
    Yes?
    Some reasons for switching…
    1. better opportunities,2. old investment reached maximum value3. you or I made a mistake in the investment call4. the fund manager which you like, moved to another fund house and you want to follow (can if his new fund house is in our universe of fund houses)
    That 5.5% begins to look like pittance. In fact it may look cheaper than actually doing your own online investment in equities in the long run.
    Does this service exist?
    Yes….

  9. Whether or not a 5.5% buying charge for alpha funds is worth it is a valid point but this blog post was about index funds, i.e. beta funds. It still is pretty funny that fund houses charge the same buying charges and annual charges for funds which have an index in their name, even though index funds supposedly do not require active management and should therefore be much, much cheaper.

  10. Freakonomics just drop a bomb shell and confirm all the doubt : All the financial derivatives are mostly a gambling con-job.

    http://freakonomics.com/podcast/stupidest-money/

    Malaysia financial market is anything but a casino for the rich and powerful to siphon the people wealth.

    First, it is lucrative business for the so call “active management”. All the funds in Malaysia are manage by financial institution that has a securities brokers house that rip off the commission from every transaction. They are no different than the Wall street wolves.

    Second. Even so call Sovereignty funds are leaking the money to brokers house. The so call “privatized Bursa” will NEVER be profitable if there is no rapid transaction from KWSP and other sovereignty funds.

    Malaysia finance institution are so distort that, none of them can survive when a prolong wave of crisis reach the shores.

    When KLSE index are 80% of market values are compose of “finance” products, there is little choice for “safe-selection index”, even if Malaysia government miraclely allow real index-funds to be setup.

  11. Again, this is an old and maybe outdated post. For example. since then FSM has started operating and their initial buy in costs can be as low as less than 1%. I still think that the comments made in the podcast you linked to applies mainly to the US markets. The truth is that alpha funds in Malaysia do outperform the market, even after fees, for whatever reasons.

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